11/06/2009 @ 7:40AM

Amnesia

On a wet, blustery Saturday night in Manhattan in mid-October, perfect for a movie at home,
Blockbuster
ought to have been enjoying one of its better nights. But only four people were riffling through the shelves at the 56th Street store–and it would have been three if Mohamad Belkir had his druthers. The 47-year-old says he would be renting from
Netflix
instead but for the fact that DVDs don’t fit into the mailboxes in his building. For now. He plans to move soon to a nicer place where the mailbox won’t be a problem.

Blockbuster is approximately where buggy whip manufacturers were a century ago. So why are investors lapping up its bonds? Despite plunging same-store sales and liquidity troubles this summer that stoked rumors of bankruptcy, demand for its B-rated 11.75% bonds due in 2014 was so great on Sept. 17 that it was able to sell $675 million, nearly double what it had planned. Why? Forget the business and follow the money, specifically the net $20 billion that has flowed into junk bond funds this year. Suddenly flush, bond managers are scrambling to find somewhere, anywhere, to put their money to work.

“There’s such a desperation for yield now, you have to wonder if people have learned any lessons” from the crash, says Berwyn Income comanager George Cipolloni, who has loaded up on junk but shunned lower-rated issues. The sickly BS are expensive now, with prices up 43% so far this year.

As for why risky assets are in vogue, look to Fed Chief Ben S. Bernanke. The $2 trillion he has pumped into the economy and his zero interest rate policy may have spared the U.S. a second Depression. But by pushing rates down, he has driven investors looking for extra yield to the riskiest paper and allowed them to lever up these bets cheaply.

The last time the monetary spigot was wide open it led to a credit bubble, a stock bubble, a private equity bubble and a housing bubble–and we all know how that ended. But instead of fear we seem complacent. One sign: The VIX Index, which measures investor expectation of stock volatility, is back down to the level of October 2007, when shares were near their highs.

As with junk companies, so with junk countries. Lithuania has been downgraded by Fitch Ratings three times in the past year, and its GDP is expected to fall 18% this year. No matter. Demand for its $1.5 billion issue of five-year bonds in early October was so great that this hapless Baltic country could have sold nearly four times as much. The yield: 6.8%.

October was a great month for basket- case issues. Venezuela sold two bond issues to domestic investors–$5 billion worth, yielding 4.5% and 3.1%. Sri Lanka, better known for civil war than fiscal soundness, unloaded $500 million (yield: 7.4%). Even Argentina, still battling in court with investors it stiffed by defaulting on $95 billion worth of bonds eight years ago, is reportedly thinking of a new issue. Quips FORBES columnist Richard Lehmann: “In this kind of market North Korea would do well.”

Or East Hampton, New York. This playground for the Wall Street elite is a financial mess. Its funds for general operations dropped from a $7 million surplus to an $11 million deficit in four years; a budget aide to the town’s supervisor was arrested on fraud charges; and the supervisor himself resigned recently after a state audit revealed no-bid contracts, misuse of funds and assorted money mischief (he hasn’t been charged). Yet the yield on its general obligation bonds, due in 2021, has fallen in seeming lockstep with the town’s financial strength this year, down a percentage point to 3.94%.

Oddities abound. Gold and Treasurys are climbing along with shares, which usually move in the opposite direction. Prices for New York apartments are falling, while those in Hong Kong, which is just as tied to the financial industry, are rising smartly again.

In the U.S., prices of so-called dirt bonds, issued by developers who planned to build whole towns before the housing bust, are climbing again. In 2004 Midtown Miami Community Development District issued $53 million in bonds to finance infrastructure work in Miami for a new complex of condos, offices and shops. Out of six tracts where buildings were supposed to be up by now, only two have been completed; the rest aren’t even under construction. The market’s reaction? The bonds, due in 2037, have jumped 22% in six months, pushing the yield down to 8.45%. “A lot of projects are going to fail, but the stupid money keeps chasing them anyway,” says Andrew Sanford, an analyst at workout firm ITG Holdings in Naples, Florida.

The biggest Bernanke bubble of all: the stock market, which has surged 56% since its March low. That at least is the message from one respected measure of value–a cyclically adjusted price/earnings ratio, or the s&p 500 divided by the average inflation-adjusted earnings of the index over ten years. Stocks now are trading at 22 times their decade-average earnings, according to Smithers & Co. in London. The average multiple going back 128 years is 16.

Blackstone, for one, isn’t taking any chances. The private equity firm timed the peak of the market perfectly two years ago when it went public at $31; it’s now around $16. It recently announced plans to take as many as eight of its portfolio companies public. When the ducks quack, you feed them.

Sure You Want to Buy That Bond?

You wouldn’t know it from the demand for its bonds, but Dubai has a one-in-five chance of defaulting in the next five years. Ukraine is really scary, but Norway is safe, according to London’s CMA DataVision, which calculates default odds on sovereign debt using prices for credit default swaps. For the default probabilities of 57 more countries, visit www.forbes.com/defaults. –Kurt Badenhausen

COUNTRY

DEFAULY PROBABILITIY*

Argentina

47.2%

Lithuania

19.9

Dubai

18.5

Russia

11.3

United States

1.8

Norway

1.3

*Probability of a country’s being unable to honor its debt obligations over the next five years.
Source: CMA DataVision.